East Asian currency markets faced severe depreciations during the 1997-1998 Asian Financial Crisis. The currencies of Indonesia, Malaysia, and Korea depreciated by between 47.6% to 35.2%. Despite experiencing similar depreciative pressures, the Hong Kong dollar (HKD) kept its value. LSE student Cyrus Wong explores how the Hong Kong Monetary Authority averted a currency depreciation and how the institution, despite successfully navigating the regional monetary crisis, lost credibility.
A cornerstone of the Hong Kong Monetary Authority (HKMA), an institution akin to a central bank, is the Linked Exchange Rate System (LERS). The main function of the LERS is to keep fixed parity with the US dollar at 1USD for 7.8HKD. This system helps automatic bank and interbank interest rate arbitrage among market participants in a free-market manner. It minimises the role of discretionary monetary interventions and has underpinned Hong Kong’s longstanding financial liberalism.
However, from 1997-1998, the HKMA intervened in interbank markets by selling or buying USD reserves. These transactions manipulated interest rates by artificially accelerating or slowing down the interbank interest rate arbitrage process. This created unpredictability for currency market participants, affecting how they took market positions. Market participants began to distrust that the HKMA would keep its promise of fixing the HKD/USD parity.
Data and Methods
I used daily financial news reports over a 520-day period to contextualise the HKMA’s interventions and to analyse their effects on the HKMA and the LERS’ credibility. The two data sources I used to measure the HKMA’s credibility were the HKD currency premium, and the difference between the London Interbank Offered Rate and the Hong Kong Interbank Offered Rate, abbreviated as the LIBOR-HIBOR differential.
I accessed the daily financial news reports through Factiva databases, which include prominent financial publications such as the South China Morning Post, Financial Times, and The Economist. I focused my search by filtering daily publications through identifying terms such as ‘LERS,’ ‘Peg,’ ‘HKMA,’ ‘HKD,’ and ‘Reserves.’
Through the HKMA’s Annual Digest of Statistics, I compiled the values for the HKD currency premium and LIBOR-HIBOR differentials. The currency premium reflected market participants’ expectations towards the HKD’s future value. Subsequently, I treated changes in the currency premium as a proxy for overall credibility in the LERS since the LERS’s mandate was to keep USD-HKD parity.
Additionally, I used the LIBOR-HIBOR differential to evaluate the effects of the HKMA’s interventions. Under normal levels of credibility, decreases in the LIBOR-HIBOR differential cause the HKD premium to increase in equivalent amounts. By matching financial news and HKMA statements to declines in LIBOR-HIBOR differentials in times where interventions were found, I compared the effect of HKMA interventions to stable levels.
Detecting Losses of Credibility from Internal and External Shocks
Whenever financial news reports detailed the HKMA manipulating interbank liquidity, the size of the change to the currency premium far exceeded its change otherwise expected with normal credibility. The excessive reaction to HKMA interventions reflected credibility losses. (See Table 2)
Whenever the HKMA intervened, inconsistencies arose between what they claimed to do (de jure commitment to fixed parity) and actually did (de facto intervention moving the parity away from defined target). The unpredictability of the interventions begets institutional distrust among market participants. This reflects the time-inconsistency problem, which can undermine the long-term credibility of monetary policymakers.
The lack of clarity around when the HKMA would intervene made the events of 1997-1998 particularly distressing to market participants. In its modern version, the HKMA has defined thresholds for interventions, specifically when HKD parity weakens to $7.85, or strengthens to $7.75. The clear guidelines permit market participants to manage price expectations and take informed market positions.
Beyond internal sources of credibility losses, I also found that events outside of Hong Kong affected the confidence in the HKD market during the crisis but did so in a non-uniform way. Expectations of the HKD’s devaluation rose intensely and instantaneously when financial news in Q1 1997 reported rumours that the Thai Baht would devalue. However, in Q3 when the Baht actually devalued, market confidence was unshaken. In stark contrast, the collapse of both the Singaporean Dollar and the Indonesian Rupiah, currencies of countries more economically intertwined with Hong Kong, caused significant uncertainty among the HKD market in August 1997.
To understand these findings, I relied on contagion theories of how financial crises are spread. The HKD market’s selective reactions demarcate between superficial ‘contagion’ caused by short term irrational fear, and actual ‘contagion’ caused by structural linkages between countries. The threat of Thailand abandoning its peg could have transmitted an irrational fear to HKD market participants. However, devaluation did not take root in Hong Kong after the Bhat devalued since there were relatively few bilateral economic linkages between Thailand and Hong Kong. On the flipside, the fall of currencies whose countries were more economically intertwined with Hong Kong created genuine cause for pessimism.
Restoring Credibility
Political figures could restore credibility through communicating their policy intent. However, the choices of political rhetoric appear to have mattered immensely. The currency premium declined (credibility increased) in reaction to public statements emphasising the strength or longevity of the peg. On the other hand, statements ensuring that the LERS’s foreign reserves were ample did nothing to the HKD currency premium.
These findings suggest that, contrary to some economists’ ideas, a mere abundance foreign reserves, which signal prudence and security, cannot bolster credibility. On the other hand, public statements by HKMA officials emphasising loyalty and longstanding trust in the LERS did bolster credibility. One explanation for this is that the statements increased the political costs of abandoning the currency board for policymakers. If they reneged on publicly made promises, it would be detrimental to their political careers. However, none of these measures improved credibility losses as effectively as the post-1998 reforms that set up clear definitions for intervention.
Conclusion
The case of the HKMA during the 1997-1998 Asian Financial Crisis illustrates the difficult balancing act of discretionary monetary policy and institutional credibility. Though Hong Kong was successful in evading a currency devaluation, the policies enacted caused considerable damage to the country’s institutional credibility. The saga of the HKMA emphasized three lessons. First, the importance of a rule-based currency board system with transparent guidelines for discretionary interventions. Second, external shocks have a larger effect if they occur in a nation that has strong, pre-existing economic ties. Third, political rhetoric around discretionary monetary policy needs to project trust even if that increases political risks for policymakers.
